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PREVENTION OF CATASTROPHIC FAILURES WITH WEAK FOREWARNING SIGNALS

Published online by Cambridge University Press:  19 November 2013

H. Dharma Kwon
H. Dharma Kwon*
Affiliation:
Department of Business Administration, University of Illinois at Urbana-Champaign, Champaign, IL 61820. E-mail: [email protected].
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Abstract

We consider the problem of a firm facing failures with weak forewarning signals. In the base model that we study, the firm watches for signals of a random arrival of a disruptive innovation and continuously updates the posterior probability that a disruptive innovation has already happened. A disruptive innovation is marked by a rapid increase in the growth rate of the market for a new technology, and it is followed by a random arrival of catastrophic failure of the firm. The firm can invest capital to adopt the innovation to prevent failure. The optimal policy is to adopt it when the posterior probability exceeds an optimally chosen threshold. We investigate the probability of failure under the optimal policy when the cost of failure is large and the arrival rate of disruptive innovation is low. The probability of failure is close to one if the arrival rate is extremely low while it is close to zero if the arrival rate is moderate. We also consider an extension of the base model to incorporate recurrence of disruptive innovation; when the arrival rate is moderate, the optimal threshold and the failure probability can be significantly larger than those of the base model.

Type
Research Article
Information
Probability in the Engineering and Informational Sciences , Volume 28 , Issue 1 , January 2014 , pp. 121 - 144
Copyright
Copyright © Cambridge University Press 2013 

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